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Herb Kohl may be retiring, but he’s not done working just yet. Earlier this week, the Wisconsin senator introduced a bill with a Republican colleague that would limit the number of loans employees can take from their 401(k) accounts but also make it easier for people to repay them. Such loans and the penalties paid for defaulting on them can eat away at retirement savings.

Herb Kohl (official photos)

The accounts – tax shelters in which employees and employers make matching contributions that are then invested to amass a retirement nest egg – have increasingly served as rainy day funds since 2008 and the economic downturn. According to a recent study by the consulting firm Aon Hewitt, the percentage of 401(k) participants with outstanding loans from their accounts grew from about 22 percent in 2007 to almost 28 percent in 2010.

Employers and 401(k) administrators aren’t required to offers loans – but their availability entices more employees to participate in the retirement plans, according to the non-partisan Government Accountability Office, which studied the issue in 2009. Now, Aon Hewitt reports, about 95 percent of the plans permit loans.

Defaulting on the loans results in a variety of tax assessments and penalties by the IRS, which regulates 401(k) plans. Most defaults occur when employees leave jobs, forcing them to repay any outstanding loans. Most plans give workers only 60 days to repay them (with interest). “This can be challenging,” Aon Hewitt notes, “and many subsequently default on the loan.”

In fact, some 70 percent of employees who find themselves in such a situation default on the loans.

The bill by Kohl, a Democrat, and Republican Senator Mike Enzi of Wyoming would allow employees to roll their 401(k) funds into an individual retirement account (IRA) independent of their employer, and they would have until that year’s tax deadline to repay outstanding loans.

While making it easier to repay loans, the bill would also limit the number any 401(k) participant can have at one time to three. Many plans already impose such limits, but some don’t. The Aon Hewitt survey found that 2.5 percent of people who had taken out loans from their account had taken out three or more. Most, about 68 percent, had taken out just one.

“While having access to a loan in an emergency is an important feature for many participants,” Kohl said in a statement, “a 401(k) savings account should not be used as a piggy bank.”

Enzi said he and the Wisconsin Democrat aim to “stop leakage in the retirement system.”

mike enzi

Most 401(k) plans also allow employees to make “hardship” withdrawals. Like loans, these withdrawals have to be repaid, but no interest is assessed. State and federal income taxes, however, must be paid on the withdrawals.

To get one, employees must document a hardship, meaning “immediate and heavy” medical, mortgage, home repair, educational or funeral expenses. Employees can also get one to prevent an eviction and, according to Aon Hewitt, this is the most common reason, accounting for about half of all withdrawals.

The bill would axe another penalty attached to these hardship cases, the one preventing employees from making any additional contributions to their 401(k) for six months after the withdrawal. Plan administrators have long objected to this restriction, and the GAO recommended in 2009 that Congress remove it.

Hardship withdrawals also climbed during the recession, rising from about 5 percent of 401(k) participants in 2007 to about 7 percent in 2010, Aon Hewitt found.

The bill, introduced on Wednesday, was referred to the Senate Committee on Finance.

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